Rating your 401(k)
401(k) accounts are typically among the largest assets held by middle- and upper-middle-income households in the United States. So naturally they draw a lot of attention—in the marketplace, in the media, and in Washington. The government, for example, is proposing new rules on reporting fees and promoting impartiality in investment advice.
Meanwhile, in the marketplace, a few start-up companies are looking to profit from the trend. One is BrightScope, which provides a rating of many 401(k) plans in the U.S. If your employer plan is rated 90 or above, it’s stellar in their estimation. If it’s rated 50 or less, it’s not.
All of this seems like a useful exercise until you dig a bit further. BrightScope’s ranking system reveals one problem. The top of the scale is dominated by plans for doctors, money managers, and pilots; the bottom, by plans for retail workers. So at least from this perspective, it seems like the rating is less about your 401(k), and more about your income—whether you’re a pilot, a money manager, or a retail clerk.
Why this is happening is understandable. Rating companies use publicly available information from the government. That information tells us, for example, that in Plan A, the average employee is saving $10,000 a year, but in Plan B, the average employee is only saving $2,000. What it can’t do, however, is adjust those figures for the relative incomes of the workers—that information isn’t available. Higher-paid workers save more generally, not just because they are higher paid but also because they need to, since Social Security replaces a smaller part of their income. In the end, rating services give a better score to the strong savers in Plan A, as opposed to the cash-constrained in Plan B, even though the reason is that Plan A’s employees make a lot more money than Plan B’s employees.
(As a technical matter, these indicators are further skewed because they are averages, rather than medians. Income, wealth, contribution amounts, and similar statistics are skewed to higher-paid workers whenever averages rather than medians are used.)
Another tricky issue involves other retirement plans. For a couple of companies I know that offer traditional pension plans, I noticed that their 401(k) ratings were low. When a company offers a traditional pension plan, it may provide lower matching contributions in the 401(k) plan. That’s because the company is shouldering the cost of the traditional pension. Also, when a traditional pension is offered, employers tend to save less in the 401(k), knowing they have other retirement benefits. Public rating services can’t figure this out, and so some companies are misrated.
One final twist. Another company I noticed was rated as having below-average investment “quality.” It turns out that the company’s 401(k) uses a number of active managers, and in the rating system those managers’ recent performance was rated poorly. Now it’s hard to know exactly how the plan was penalized given that the ranking system is not fully disclosed. Nonetheless, my guess is that over the period the managers were rated, a specific metric of performance was below that of other plans. But saying “active money managers in the plan had below-average performance during a given period” is different than saying they are low quality.
These types of ratings can still be useful. For example, if you are a pilot, you can compare your employer’s plan with plans for other pilots. Same for workers in health care, manufacturing, oil, drugs, accounting, and so on. If you know the companies your firm competes with, a useful step is to see how your employer’s 401(k) stacks up against theirs. But I wouldn’t spend much time thinking about why your plan is worse than the pilots’ plan—unless of course you are a pilot!
Rating services of all kinds are hoping to replicate the success of Morningstar, whose star-rating system became the de facto industry standard for mutual funds. With the caveats I noted so far, there’s only so much an individual can do in using the latest 401(k) ratings. 401(k) plans are just complex, with plenty of moving parts.
What it seems we need is not just a ranking system, but an interpreter, or a user guide, providing us with all of the caveats and qualifications for a given ranking. It would be nice to have a simple metric for your 401(k) plan—is your plan one star or five stars? For the foreseeable future, that seems highly unlikely.
Notes:
- All investments are subject to risk.
- The link to BrightScope.com will open a new browser window. Vanguard accepts no responsibility for content on third-party websites.
We doubt this will fly. Part of the problem is hostile comments and reports tend to predominate on open forums and ratings. Just the way our minds work. We would be concerned about libel issues. Rating publicly available information on funds, stocks etc is a very different business model.
Any for-profit rating service also has inherent conflict of interest challenges in monetization models. How the rating company is paid and by whom needs to be fully disclosed.
Aside from for investment and plan provider sales purposes, we doubt there is any real demand for these ratings.
Here are my comments about the BrightScope “66″ score of my plan:
(1) Looks like you only focus on the 401(k) – so, for example, you fail to note that my company maintains and has not frozen their defined benefit pension still allow new associates to enter), and we still offers access to and company financial support for retiree medical coverage (still allow new associates to enter). So, the 401(k) comparison is taken out of context for the entire retirement benefit package, right?
(2) How do you adjust the data when a company suspends its match? For example, you want us to compare to firms such as Amex – who suspended their match – if I am not mistaken.
(3) What does it take to have a participation rate of “Great”? In 2007, our participation rate was 95+%. If that is not “great”, what is?
(4) Certain funds (see below) have not been in the plan since 2006. What else is out of date?
1. Gartmore Nationwide S&P 500 Index Separate Acct. 10%
2. Fidelity Contrafund 4%
3. Gartmore Growth Separate Account 3%
(5) The plan scores out as above average and with lowest fees in all categories, except average in “company generosity” So, is “company generosity” that heavily weighted, so dominant, so as to drag the overall score for this plan down to an average rank of 66?
I have 30+ years of benefits experience. The analysis and the and the authors conclusions are not adjusted, nor any “head’s up” notice, nor any disclaimer, about more recent…
Another point – exactly what is Joe Average worker supposed to do if his plan is not rated favorably – quit his job? The idea behind the rating concept is that he should ask his Human Resources department to improve the plan. Let’s face it, complaining too much at work is probably the quickest way to get laid off right now, and it’s pretty hard to find a new job these days, too, so I think Joe Average Worker is stuck with his “below-average” plan, or he can open his own IRA if he qualifies with income limits.
BrightScope Co-Founder and President Ryan Alfred has made an official response on the BrightScope Blog: http://www.brightscope.com/blog/2010/03/18/an-open-letter-to-vanguards-steve-utkus/
Steve, this might have been a useful blog post, but you kind of missed the mark with your interpretation of what BrightScope is and does. Perhaps you should call them and learn more.
Steve is right on the dot on this one. You can’t rate plans based on the publicly available information since they don’t provide the in-depth details needed to accurately rank a plan as good/bad.
As a principal of a national TPA, I see the data that is readily available. Extrapolating this data to determine the quality of a plan is misleading.
Why is it so diffcult to get a morningstar rating on my accounts when I pull up my 401K
I do not think any rating service is of much value unless it places an emphasis on cost. As stated on your website and literature, cost matters. Vanguard’s founder, John Bogle, has been addressing the issue of cost for a very long time as well as the fact that active management to fails to provide any benefit in an extremely high precentage of the time. Active management is just a drain on an investor’s money. My employer’s 401 plan had (since replaced) an S&P 500 index fund for which I was charged an expense ratio of 0.6%. What is Vanguard’s ER, 0.18% or less? All of the other funds in my 401 are actively managed funds charging 1.2% to underform. These two failing, expenses and active management, are just as important as low participation.
A rating system should include a risk/reward analysis of your investment mix, regardless of the total value. Given that the individual has already decided how much to invest, the added value is in helping them (me) choose HOW to invest.
This is advice to Vanguard as well. Why not show us a profile of our individual investments so we can see their correlation with each other; their relative merits in fitting each part of their investment niche? Morningstar is much better at this, but I get tired of manually entering my Vanguard transactions.
Maybe Vanguard could provide an export facility so that we could import our actual holdings and transaction dates to a source that provide useful analysis?